Traders Stare Down The 'Fiscal Cliff' - Is This A Stock Market In Denial?

In recent weeks I have come to the conclusion -- as many have -- that the only players left in the markets aren't human. It seems the trading algorithms are simply set to buy the dips. In all honesty, this irrational market behavior is not good for the markets. In fact, it is never a good thing for markets to act irrationally. We should be able to rely on market pricing that correlates with economic conditions and that hasn't been the case in recent weeks. The markets are fully ignoring the recession implications of the "fiscal cliff."

Even if a fix on the "fiscal cliff" were to occur, it will be some form of compromise that results in economic contraction to an economy that can't withstand economic contraction. Consider that the probability of entering a recession in the first quarter of next year is very high and we are priced - once again - within striking distance of the post recession highs on the Dow (NYSEARCA:DIA) and S&P (NYSEARCA:SPY).

Mind you I am not complaining - I'm just perplexed. I am on record as being bearish tech stocks, financial stocks, crude oil and gold and bullish the dollar and all those calls are profitable. I made those calls in September and added my last positions the Monday following the announcement of QE3. I am on record on these calls in a number of articles. Using the Monday following the announcement of QE3 as a reference point, let's look at sector ETFs to see how those market calls have fared:

The recent rally in stocks hasn't changed my view at all and I still see stocks testing the 2009 lows in 2013. I see no way around this. I have offered a number of arguments supporting this call. Today I want to take a little different view on the matter of the "fiscal cliff." I want to do a "what if scenario" by taking a look at where we would be without the massive fiscal stimulus that has been injected into the economy over the last several years.

Before I get into that though I want to share with you some comments made by John Browne -- former Conservative Party Member of the British Parliament and currently serving as Senior Market Strategist for Euro Pacific Capital. Browne weighed in on the issue of the "fiscal cliff" on Fox Business Network on Thursday. If you want an honest and qualified assessment of the "fiscal cliff" watch the video.

Browne's conclusion -- there is no solution to the "fiscal cliff" that avoids recession. He is right. I've been sounding the same warning regarding the "fiscal cliff" for some time now. Back on September 7, of this year I wrote Market Euphoria Continues As We Get Ready To Jump Off The Fiscal Cliff. Browne's comments echo my own sentiments in every respect. The following is an excerpt from my September article:

Most everyone shrugs off the "fiscal cliff" issue assuming that we will deal with it after the election. That is an interesting perspective and another case of an irrational response. How exactly will we deal with it? There is no resolution to the "fiscal cliff" issues that end in a positive outcome. Consequently we just shrug it off and bet on Bernanke to give us our QE fix. The CBO sees 2 scenarios.

The first scenario is that we do go over the "fiscal cliff" and fail to extend the tax cuts and implement spending cuts - the result being a GDP contraction ending up in a recession in 2013. Unemployment moves back up to 9% under this scenario. Based on Congressional inaction it is a virtual certainty that this is the scenario that will occur.

The second scenario is that we continue to fund entitlements through deficit spending and continue to grow the federal debt. The CBO says that such a course, although in the short term resulting in a better outcome, after 2013 it will be unsustainable.

I have been advised by some that my commentary on matters economic should not be political. My response - how can I possibly address a matter that undermines the economic future of the United States based almost entirely on political dysfunction without making political commentary?

One thing I won't do today though is present a partisan position as neither party of Congress nor any President in the last 30 years escapes the burden of responsibility. Let me offer a brief summary of why we find ourselves so focused on the "fiscal cliff" today:

In 1984 President Reagan passed the Secondary Mortgage Market Enhancement Act to improve the marketability of private label passthroughs, which declared nationally recognized statistical rating organization AA-rated mortgage-backed securities to be legal investments equivalent to Treasury securities and other federal government bonds for federally-charted banks.

In 1992, President George H.W. Bush signed the Housing and Community Development Act of 1992 requiring Government Supported Enterprises to meet affordable housing goals set annually by the Department of Housing and Urban Development (HUD) and approved by Congress. The initial annual goal for low-income and moderate-income mortgage purchases for each GSE was 30% of the total number of dwelling units financed by mortgage purchases and increased to 55% by 2007.

In 1999 President Clinton signed the Gramm-Leach-Bliley Act effectively repealing the Glass-Steagall Act thereby broadening the scope of commercial bank investments.

These three pieces of legislation allowed, encouraged and even mandated that commercial banks engage in high-risk investments. The result was the bank crisis of 2008-2009 that was of such magnitude that it brought the United States banking system to the brink of collapse.

Solution - more government tinkering. First came the bank bailout with TARP. That was followed by an extension of the "Bush tax cuts" signed into law by George W. Bush and extended by Barack Obama. Then came the American Recovery and Reinvestment Act of 2009 that extended unemployment insurance benefits; provided direct cash payments to qualified recipients; provided funding for work projects; subsidized healthcare for the unemployed and increased food stamp benefits.

The tax cuts and stimulus spending served to keep us on the plus side of GDP growth since coming out of the recession but the cost has been huge. The chart below shows the impact deficit spending has had on GDP:

Click to enlarge

To construct the chart I plotted the real GDP quarterly change in dollars and then reduced that number by the amount of the quarterly deficit. My purpose in presenting the chart is to demonstrate that absent unprecedented deficit spending our GDP would have fallen every quarter since the recession. There is no quarterly number on the "Real GDP Less Deficit" line that exceeds zero. To better understand how fiscal stimulus has impacted GDP the next chart reflects real dollar GDP and real dollar GDP reduced by the quarterly deficit.

Click to enlarge

These charts show that absent massive fiscal stimulus we would have remained in recession with quarter after quarter of declining GDP. As we ponder the matter of avoiding the "fiscal cliff" Congress and the President are stuck in a "Catch-22" situation. One must wonder what stock traders see as a solution that will work if only Congress gets to work. To me that position is simply naive.

Quite honestly there is no solution that avoids recession short of reneging on the agreement Congress entered into in 2011 that promised to allow the "Bush tax cuts" to expire and the "sequestration cuts" to be implemented. In other words, absent a continuation of the status quo we are going into recession.

President Obama's proposal that tends to ignore spending cuts and promises to impose tax hikes on those making more than $250,000 a year is the best of the proposals on the table in the short run in that it is the closest option being considered that promises a continuation of the borrow and spend policy that has provided the life-support stimulus this sick economy requires. The problem though is that this approach is simply unsustainable.

Consider that we have run a monthly deficit average of $100 billion since the recession. In spite of that, the unemployment numbers have not improved significantly at all and GDP has not shown any inclination to grow on its own. If we make any move whatsoever to address the deficit spending and debt trajectory it will present a drag on the economy.

No "Grand Bargain" that avoids recession exists. Pundit commentary that offers sharp criticism of Congress continues to assume the problem is divisive partisanship. I don't think so at all. It is more a matter of deciding whether or not we should try to avoid the inevitable recession a little while longer.

We can take the President's more of the same approach and risk further credit downgrades as our debt trajectory skyrockets out of control or we can take the House Republicans approach and start dealing with the debt and deficit and force immediate recession.

We are a nation that is still plagued with a leverage problem. We either need to increase leverage by expanded borrowings and in so doing, increase M2, which leads to inflation as the Fed has attempted to do or decrease borrowings through a process of further debt reduction. We've failed in creating the former - increased leverage - which leaves us no alternative but the latter - decreased leverage. This will occur as natural market forces finally override the less natural artificial stimulus that has failed to jump start an economy still dealing with the aftershock of the "Great Recession."

The stock market has a long history of slow, steady growth interrupted by rapid and deep pull backs. It is a buy-side bias that often times overshoots to the upside and requires re-calibration. Those re-calibration moves can be rapid and significant. As a strong proponent of trade structure I look at each trade I enter by evaluating a probable profit objective and a realistic loss level. If the ratio of potential profit relative to risk is less than 2:1 it is not a trade worth making.

As the charts above reflect it is only thorough massive deficit spending that we have managed to keep GDP in positive territory. Let's assume we do reach a compromise -- which is not likely until Congress enters into the debt ceiling debate in 2013 - and agree to a combination of tax hikes and spending cuts in the $150 billion range. We are still contracting a very fragile economy by about 1% of GDP.

Furthermore, if that is all we managed to come up with we would continue on a debt trajectory that will increase at a rate in excess of $1 trillion a year. That most assuredly will result in a credit downgrade and that is the best-case scenario in my opinion.

Although I can't begin to fathom how this market continues to remain at such lofty levels with so many headwinds facing us in 2013 I wouldn't count on it lasting much longer. Markets can veer way off course on occasion but they eventually get it right in the end.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am short a group of tech stocks, financial stocks and crude oil. I am long VIX.